Spanish ratings cut drives bond yields to 6 percent

LONDON (Reuters) - Spanish government bond yields rose to the 6 percent danger level on Friday after a credit rating downgrade stoked fears about the euro zone's heavy debtors, with a smooth Italian debt auction providing only limited relief.

Standard & Poor's cut Spain's credit rating by two notches to BBB+ late on Thursday and maintained a negative outlook, citing the deterioration of government finances and weakness in the Spanish banking sector.

In reaction, the 10-year Spanish bond yield hit a high of 6.03 percent - a move that also reflected weak Spanish retail sales data and the threat of further downgrades. The yield was up 6 bps at 5.91 percent in late European trading.

"It's difficult to see where any good news for Spain comes from ... people are perhaps taking the view that now the downgrade has come for Spain, what could happen to Italy on that front?" said John Davies, strategist at WestLB in London.

The Spanish yield has briefly broken above 6 percent several times in recent weeks. Markets are wary that a sustained move would draw comparisons with the swift rise to an unsustainable 7 percent seen in Portuguese and Irish yields before both countries sought international bailouts.

The scale of the region's debt problems were highlighted by S&P's head of European ratings, Moritz Kraemer, who said there were downside risks to almost all euro zone sovereign ratings.

Italy's borrowing costs rose to 5.84 percent at a sale of 10-year bonds on Friday - their highest since January - but the amount sold was close to the maximum 6.25 billion euros Italy had indicated it hoped to raise.

"To sum up, at least no further bad news, nothing to provide further fuel to the sell-off we have had in periphery paper this morning," Michael Leister, strategist at DZ Bank, said.

The 10-year Italian bond yield hit a session-high of 5.78 percent earlier but by late European trading was up only slightly on the day at 5.65 percent.

CRITICAL LEVEL

German Bund futures settled 22 ticks lower on the day at 140.70, having earlier hit a record high of 141.38.

David Sneddon, managing director of technical analysis at Credit Suisse, said 141.40-141.50 was a critical inflection point in the Bund future.

The bank's strategy was to sell into that level but to quickly reverse that trade should it be broken to the upside. The market was susceptible to short-covering above that level, given that the market currently had a lot of short positions on the Bund, he added.

Fundamentally the backdrop remained supportive for safe-haven debt, with the global economic recovery still fragile given the challenges posed by the euro zone debt crisis.

Across the Atlantic, data showed the world's largest economy grew by less than expected in the first quarter of this year.

"If anything the data has been mildly supportive for bonds and I think the fact that bonds have failed to make any progress ... just tells you that there is some position closing going on," said a trader. Trade was expected to be thin on Monday, with euro zone debt markets shut on Tuesday for European public holiday.